RATING METHODOLOGY FOR TRADING COMPANIES

Rating Methodology
This rating methodology explains ICRAs approach in analyzing business and financial risk for trading and
processing companies. ICRA defines such trading companies as companies whose primary business activity
involves the merchandising and distribution of large volumes of basic commodities, such as agricultural,
metals, building & construction material, oil/energy. Such companies have substantial physical inventories of
commodities and assets that may be utilized for value addition or logistics.

he objective of the rating methodology is to provide a reference tool that can be used to evaluate the credit
profiles of companies engaged in trading businesses. It aims to help issuers, investors and other interested
market participants understand ICRAs approach in analyzing quantitative and qualitative risk characteristics
that are likely to affect rating outcomes. This methodology does not include an exhaustive treatment of all
factors that are reflected in ratings but would enable the reader to understand the rating considerations that
are most important.

Overview
India is an important consumer as well as supplier of agriculture, energy and metal commodities. Owing to its
large population base, it is the largest consumer of sugar and tea and the second largest consumer of wheat

July 2012
and rice. It is also the fourth largest edible oil market after USA, China and Brazil and is witnessing an upward
trend in imports owing to lagged domestic production growth. Further, despite the agriculture sectors
declining contribution to the overall GDP, Indias arable land of 159.7 million hectares is the second largest in
the world, and it is among the top three global producers of a broad range of crops, including cotton, wheat,
rice, pulses, fruits and vegetables. In addition, the rapid growth of user industries such as steel, power,
construction and automobiles has led support to the demand of industrial metals and energy commodities
such as iron ore, copper, coal and crude oil. In terms of growth potential, the commodity industry is well
placed given the favorable demand prospects with growing population, affluence levels and strong long term
demand from the industrial sector. As a result, India is amongst the critical growth markets for global
commodity giants who are looking to consolidate their presence and strengthen their positioning across the
value chain in the country.

In India, trading businesses have traditionally been dominated by a vast number of small, unorganized outfits
largely in the form of family run businesses. Barring a few sectors such as oil & gas, energy, most of the
trading business segments are extremely fragmented. However, even as the businesses remain unorganized,
the share of organized players has been increasing gradually with relaxation in Governments trade and
investment policies. Some of the organized segment players have strong parentage, including large global
players, that have recognized India as an important market to have presence in citing the growth prospects
and its positioning in the global commodity trade. Besides having benefits of diversification, such players
benefit from the strong risk management practices, deep understanding of global commodity markets and
wherewithal to withstand inherent business risk giving the equity support from their parents. Apart from
having a diversified portfolio, most often such players also strengthen their business through vertical
 Rating Methodology Trading Companies

integration measures. ICRAs rating portfolio of trading companies includes few large organized multi-
commodity trading companies and numerous smaller companies, typically engaged in a single business
activity.

Some of the businesses rated by ICRA may also be engaged in trading of branded products such as auto
components, medical equipment, electrical equipment, building & construction materials and even
franchisee of branded apparels. For analyzing such companies, ICRA looks at various parameters that may be
specific to an individual business. Some of the common ones would be a) the level of gross margins offered
by OEMs, b) quality of retail presence, c) relationship with the OEM, d) nature of contract (related to
exclusivity, region or buyback arrangements).

Given the fact the trading business operates on wafer thin profitability and provides limited scope of
differentiation or value addition, ICRA considers risk management as a crucial factor for commodity supply
chain companies. However, given the fragmented nature of the business, most of the players in the
unorganized segment lack proper framework for risk management and information systems. Despite the
promoters of these businesses having vast experience, dearth of standardized business management
practices exposes them to market risk.

Scale, Market Position & Diversification

In line with the rating methodology for most of the other corporate sectors, assessment of a trading
companys scale, market position and business diversification play an equally important in reflecting a
companys competitive strength in the markets it serves, its bargaining power with suppliers and customers.
In India, trading has traditionally been a fragmented business with exception of few sectors such as oil &
gas and energy which are majorly controlled by public-sector enterprises.

In India, most of the trading businesses be it agricultural commodities, metals, building & construction
material have traditionally been managed by family run businesses. Such business outfits though have vast
experience in their fields but generally lack strong market position and even diversification. Such business
traits may however vary from business to business. For instance, the share of organized segment in trading of
agricultural commodities, especially rice has attained a reasonable share of the market over the years, while
some of the businesses especially metal trading etc. continue to remain highly fragmented. With significant
export opportunities, many of the players have gradually attained meaningful scale and market position in
agricultural commodity trading and have also explored both backward & forward integration measures to
strengthen their business profiles.

Nevertheless, given the un-organized and fragmented nature of trading business in India, the importance of
scale and market position may command different weighting across sectors and qualitative factors such as
experience of the promoters and their understanding of the business may be acknowledged while assessing
the business risk.

Some of the key parameters analyzed by ICRA include:

- Level of trading volumes
- Relationship with suppliers (producers, farmers etc.)
- Relationship with customers, share of business & bargaining power
- Presence Regional or Nationwide
- Customer concentration
- Presence in backward supply sources or front-end marketing/distribution

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 Rating Methodology Trading Companies

Companies that score highly on the above parameters are often able to source products at competitive
prices, spend less on logistics and provide quicker delivery of products. As a result, companies with larger
market share are able to generate higher margins over time by exploiting any regional discrepancies in price
and short-term imbalances in supply and demand.

Level of business integration

Apart from enjoying strong market position and diversification, trading businesses also strengthen their
business profile by vertically integrated their operations. Some of the larger players in the trading business,
especially the ones engaged in agricultural commodities such as edible oils, wheat, rice etc. have also
integrated their businesses by exploring possibilities of both backward and forward integration. For instance,
companies engaged in trading of edible oils have strengthened their sourcing by acquiring processing units on
one hand and have also created marketing brands on the other with the objective to absorb value across the
chain. Besides improving profitability, such measures also help companies in mitigating the impact of
fluctuation in commodity prices to some extent.

While backward integration measures prima facie add strength to a companys business model, the extent of
investments required in backward integration and the ability of a company gain critical importance in an
attempt to transform a business model. For instance, a steel trading outfit or a business engaged in trading in
rubber may not have adequate balance sheet strength or capabilities for setting up a steel mill or tyre
manufacturing unit, respectively. As a result, certain businesses by their very nature have limited vertical
integration opportunities. Thus, ICRA differentiates its approach depending on the sector the business
belongs to and follows a comprehensive benchmarking evaluation with peer group, while assigning ratings.

Business Risk
Just like any other sector, trading business is also exposed to multiple types of risks arising out of market risks
from change in commodity prices, credit risk from exposure to multiple counterparties, risk from hedging and
trading activities, and risk of loss during storage or transit etc. Given the volatility in margins arising out of
these variables, risk management is an important competency and a key rating driver in this industry. ICRAs
assessment of the risk management practices includes, but not limited to, the following:

A) Market Risk
One of the key risks that trading companies face is the market risk arising out of volatility in commodity
prices which may be influenced by trends in international commodity prices, demand-supply dynamics and
macro-economic trends. Exposure to a commodity is either taken through physical possession or through
financial derivatives and the risk may be hedged through back-to-back transactions or through counter
purchase agreements on local/global exchanges. In assessing market risk, ICRA evaluates the companys
trading and hedging strategies, managements track record in the business, volatility in earnings from its core
business segments and longevity of the companys operations in each of its major market segments. In
addition, the extent of market risk in a business is also influenced by inventory holding period. Business with
relatively higher inventory holding periods owing to factors like processing, logistics etc may face higher
market risk compared to the ones where turnaround is faster like trading in metals etc.

B) Regulatory Risk
After market risk, the other prominent challenge that trading companies face is the potential change in
regulations related to commodity trading. In India, the regulatory environment is fairly stringent, restricting
free trade, sourcing, warehousing and even pricing of essential commodities. In an attempt to strike a
balance between the welfare of the agricultural community and ensuring supplies at competitive rates, the
Government also engages directly in sourcing and pricing (by setting minimum support prices) of essential
commodities. Besides, the Government also implements restrictions in imports/exports from time-to-time

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 Rating Methodology Trading Companies

depending upon the prevailing market conditions. Import duties are often altered to align with the interest of
the local industries. Such risk expose companies engaged in trading of essential commodities to regulatory
risk further emphasizing the importance of diversification. Given these considerations, ICRA carries out
detailed analysis of the regulatory framework and makes appropriate adjustments to the analytical
framework for trading companies. For instance, often, businesses engaged in imports of certain commodities
such as Palm Oil etc. tend to benefit from an import-duty cover, wherein substantial proportion of the
profitability is driven by such trade policies, resulting in fluctuation in earnings with change in policies.

C) Counterparty/Credit Risk
Involvement of multiple counterparties in trading transactions also exposes a company to credit risk, and
necessities a comprehensive credit risk management system for identifying, assessing and monitoring credit
risk with respect to their customers and suppliers. Credit risk can be mitigated through managing
counterparty exposure through risk weighted limits and customized credit terms determined following a
credit appraisal process. Additional risk mitigants may include third party guarantees, collateral agreements,
margin deposits and trade insurance measures. The implementation of such measures in a tightly monitored
environment is considered favorably by ICRA.

The trading companies are exposed to multiple other risks across the supply chain, including but not limited
to, risk of loss or damage during storage or transit, foreign exchange risk or events of political risks. While the
loss on physicals can be addressed by taking adequate insurance cover for general and specific liability, a
company can hedge its foreign currency exposure through derivatives contracts. In addition, political risk
insurance provides cover for events such as war, export restrictions, seizure or blockage of funds, prohibition
of transfers in foreign currency among others. ICRAs evaluation is based upon the importance given by a
company to these risks and is reflected by its insurance and forex policies.

Financial Policies
Apart from analyzing business strengths, tolerance for financial risk is another key rating consideration while
rating trading companies. This factor seeks to assess how financial policies will impact future decisions on
leverage and liquidity management. However given the unorganized nature of most trading oriented
businesses in India, financial policies are often not well defined among companies. As a result, it becomes
challenging to assess a companys risk taking capabilities and its impact on creditworthiness. With these
constraints, ICRA gives higher weightage to qualitative aspects resulting from management meetings. Key
issues include a) target return and leverage indicators, b) in-organic growth plans (size of potential
acquisitions etc.), c) funding plans and d) future plans to improve capital efficiency and liquidity.

In assessing a companys credit profile, ICRAs analyses financial leverage on both unadjusted and adjusted
basis. The two material adjustments applicable to the calculation of adjusted ratios include a) impact of
operating leases (related to warehouse leases, vessel chartering etc.) and loans from promoters/group
companies. ICRA observes that most of trading businesses in India being family run tend to rely on promoter
funding (usually in the form of loans) in addition to bank borrowings. As part of working capital management,
companies also discount receivables. In most cases, such trade receivable financing is not recognized on a
companys balance sheet. Thus, ICRA includes such financing arrangements as part of debt.

Some of the key indicators observed by ICRA include

- Leverage (i.e. Total Debt/Net Worth)
- Total Debt/EBITDA
- Fund Flow from Operations (FFO)/Interest Expenses and
- Retained Cash Flows (RCF)/Total Debt

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 Rating Methodology Trading Companies

Assessment of Liquidity
Trading business is characterized by volatility in earnings and cash flows due to inherent volatility in the
prices of commodities and changes in market demand and supply conditions, which results in fluctuations in
working capital requirements. Business engaged in trading of agricultural commodities such as wheat, rice,
sugar, cotton etc. tend to also have seasonality in their business, which also results in funding requirements
being exceptionally high during the procurement season and relatively low during other parts of the year.
This is particularly common across companies/trading firms with limited diversification. Further, funding
requirement also tend to be a function of a companys growth plans.

In India, trading firms generally rely on banking system to meet their working capital requirements and have
limited access to capital markets. Given the stringent lending norms, access to bank funding at times
becomes a time consuming process, especially for start-up or fast-growing companies, resulting in liquidity
issues or even delays in timely servicing of debt obligations. Given the critical importance of liquidity in this
industry, we consider managements approach and track record on proactively maintaining sufficient excess
liquidity to absorb any reasonable increase in commodity prices or other events that could stress liquidity.

Management Quality & Bandwidth

All debt ratings necessarily incorporate an assessment of the quality of the issuers management, as well as
the strength and weaknesses arising from an issuer being part of a conglomerate or large group. In case, the
issuer is among the stronger entities within the group, its past track record and future plans in supporting
other group companies are analyzed. Usually, a detailed discussion is held with the management to
understand the business objectives, plans and strategies, besides the outlook on the issuers industry. Some
of the other points assessed are:
- Experience & Commitment of the promoter/management in the line of business
- Ability and willingness of the group to support issuer through capital infusion etc.
- Managements policies on leveraging and hedging commodity & foreign exchange risk
- Growth plans, investments/acquisition plans in new areas/projects
- Business & Financial strengths of other companies within the group

Other Rating Considerations

Apart from quality and experience of management, assessment of corporate governance, quality of financial
reporting and information disclosures are given considerable weightage while assigning ratings. Among the
areas of focus in corporate governance are presence of an audit committee, financial expertise and level of
board oversight and thought process on the companys measures of managing trading risk, the incentives
created by executive compensation packages, related party transactions, interactions with auditors, and
ownership structure.

The assessment of these factors can be highly subjective and variable over time. Ratings may include
additional factors that are difficult to quantify or that only have a meaningful effect in differentiating credit
quality in some cases. Such factors include the usage of technology in business, reputational risk, changes in
consumer and business spending patterns, competitors strategies, and possible government interference
and last but not the least macro-economic trends. The analysis of these factors remains an integral part of
our rating process.

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 Rating Methodology Trading Companies

ICRA Limited
An Associate of Moody's Investors Service

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